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How Much Tax Do You Pay on Lawsuit Settlements?

Your lawyer has secured a settlement for you, and you’re using the money to support your physical and emotional recovery. However, you may still wonder how it will affect your taxes the following April. Today, we’ll discuss what you should know about taxes and personal injury settlements in Texas.

It’s crucial to clarify that this post approaches the topic from a general standpoint. Depending on the circumstances of your case and the type of settlement you received, you may have to follow more specialized advice. You should refer to your lawyer’s advice for specific information about your settlement’s taxability.

State Taxes on Settlements

In Texas, you will not have to pay state taxes on any portion of your settlement or award.

The Lone Star State is one of the nine in the U.S. that does not have its own separate income tax, instead collecting revenue through sales, use, and property taxes. Further, in 2019, roughly three-quarters of the electorate approved Proposition 4, which added a constitutional amendment barring the state government from establishing an income tax.

The Federal “Actual Damages” Rule for Settlement Taxes

According to the Internal Revenue Code, the federal government cannot tax most income a person derives from settlements or court awards. For example, you will not have to pay taxes on compensation for:

  • Hospital or clinic bills
  • Physical therapy and rehabilitation
  • Home renovations to improve accessibility
  • Pain and suffering
  • Lost quality of life
  • Lost ability to enjoy spousal companionship (“loss of consortium”)

Note that for income from compensation to be non-taxable, it must be directly related to the physical injuries you sustained. The IRS calls this income “actual damages.”

For example, if the compensation you earned for emotional distress was not directly related to a physical injury, the IRS may regard that money as taxable because the compensation is not “actual damages.”

Punitive Damages and Federal Taxes

If you win your personal injury case at trial, the judge may award you punitive damages on top of your claimed losses. The goal of punitive damages is to punish the offender and deter others from committing the same negligent behavior that led to your accident.

Since you do not claim punitive damages, they are technically unrelated to your physical injuries (not “actual damages”) and, therefore, taxable.

Lost Wages and Federal Taxes

The “actual damages” rule applies to the piece of your settlement covering lost wages. So long as your compensation relates directly to the physical injuries you sustained, it will not be taxable.

For example, John wins two lost wage awards in the same trial: one relating to a personal injury claim and the other as back pay in a wrongful termination claim. He will not have to pay taxes on the personal injury award. However, he will have to pay Social Security and Medicare taxes on the wrongful termination award.

Interest and Federal Settlement Taxes

Let’s say you secure a settlement or win compensation, but the insurer does not pay them immediately. They will then owe you interest on the original award. Interest on settlements or damages is taxable, just like interest on a savings account, CD, or loan to someone else.

How to Prepare Federal Settlement Taxes

Your lawyer will advise you on which pieces of your settlement or award are taxable and how to list them when you file. For example:

  • “Actual damages” – You do not have to list actual damages from your physical injury on your returns or factor them into your income.
  • Non-“actual damages” – List pieces of your settlement that do not directly relate to your physical injuries as “Other Income” on Form 1040 Schedule 1.
  • Punitive damages – You should also list punitive damages as “other income” on Schedule 1.
  • Interest – Report interest from a settlement or award reported on Form 1040 as “Interest Income.”

If you anticipate that the total federal taxes you owe on a settlement exceed $1,000, you may have to calculate and pay estimated taxes using Form 1040-ES. Talk with both your lawyer and tax preparer about how this process works.

Consult a Texas Personal Injury Attorney

The team at Gibson Hill Personal Injury thoroughly understands settlement tax laws. We’ll help you understand the IRS’s instructions as they apply to your case so you can avoid unnecessary penalties. Contact us at 512-580-8334 for a consultation with one of our Texas personal injury attorneys.